Munger's Mental Model for Success

One of the most underrated investors around is Charlie Munger. OK, maybe he's not really underrated, but his partner at Berkshire Hathaway -- you know, the famous one, Warren Buffett -- casts a pretty long shadow. So Charlie's own brilliance is often overlooked.

Back to Charlie. He's written that to be truly successful at investing, you need to use many different mental models, from many different areas. He says he has about 80. (No wonder he's so good!) While I don't have that many, I do have one which I share with him.

Back in the day, I was a biochemist. (That's one reason I'm the Fool's online biotech editor now.) And part of that job was graphing data, looking for overall results while ignoring the noise, something helped by expanding the scale. Assuming the data is there, a longer scale means seeing the overall direction of movement without being distracted by the short-term, up-and-down bounce of the data's noise.

It's all about time scale
For instance, this graph.

For this stock price graph, you see that it went nowhere for a few months (that's the time scale) and then declined steadily toward the end. Time to bail, right? Especially after that 50% decline.

Then there's this graph.

If you saw this pattern over several months, would you hold? It went down, it seemed to recover, and then it started falling again. Plus, it was bouncing all over the place while doing that. Maybe not.

However, if you expand the scale and take the long view, something Munger does, this is what you get.

The stock, McDonald's in this case, actually went up 140% from July 1, 2001, through July 1, 2008, the time shown (and, after having survived the 2008 crash, is up some 200%). Those two shorter time periods were just part of the noise among the broader, rising signal. About the only part that should have worried investors in McDonald's during that seven-year span was the 50% decline in late 2002. If you remember, that was when analysts worried that the company's growth was over, which management promptly showed to be groundless.

In Fooled by Randomness, Nassim Taleb writes about this very thing. Take too short a time frame, and what appears to be a signal is actually just noise. As the graph above shows, the signal is the upward movement, the noise is the daily and weekly -- even monthly -- fluctuation.

Beta, beta, who's got the beta?
The amount of fluctuation a stock has, relative to some index -- usually the S&P 500 -- is called beta. And it's a number a lot of people pay very close attention to, because it is supposed to represent risk. After all, if the S&P 500 drops by 5% in a month and your stock drops by 10%, which you might expect with a beta of 2.0, you're out more money that you would have been had you invested in the index. Except, many companies with high betas can actually be very good investments.

Source: Capital IQ, a division of Standard & Poor's; data is for the trailing 12 months.

All but one of those companies have more cash than debt, they all have generated more free cash flow than net income, and they all have good prospects going forward. So what if their five-year betas -- what many financial sites usually report -- are all above 1.8? During the past five years, the period the above beta covers, Titanium Metals, for instance, returned an average of 27.4% per year! And being the major player in its space, its prospects are great.

If you like the prospects for any of these companies after having done your research and decide to buy, expect the price to jump around. The betas show they have in the past, and they're likely to do so in the future. But don't worry about it. No less an investor than Peter Lynch commented that most companies' stock fluctuates by 50% in an average year. For the long-term investor, that shouldn't be a concern.

What's more important than beta is the soundness of the business. Look for strong balance sheets, growing revenue and net income, and plenty of free cash flow. Beta is nothing more than noise.

In other words, don't pay too much attention to the close-in view, because it doesn't represent the true picture. Fortunes are made by backing up and investing over longer time frames.

At the Motley Fool Stock Advisor newsletter service, we focus on the business, not the daily, weekly, even monthly fluctuations of the stock price. We're after the McDonald's and Titanium Metals of the world, looking to hold them for at least three to five years. And that's served us very well. Over the past eight-plus years, our recommendations have returned an average of 55% each, crushing the average returns of the S&P 500.

To see our latest two picks -- the newest issue was just released -- take a free, 30-day trial to Stock Advisor today.

Jim Mueller owns shares of Intuitive Surgical, but has no position in any other company mentioned. salesforce and Intuitive Surgical are Rule Breakers choices. Titanium Metals is a Stock Advisor selection. Berkshire Hathaway is a recommendation of Stock Advisor and Inside Value, and the Fool owns shares of it. The Fool's disclosure policy has a beta of zero and thinks beta is worth precisely that.